Level 3 Communications Q4 2008 Earnings Call Transcript

| About: Level 3 (LVLT)

Level 3 Communications, Inc. (NASDAQ:LVLT)

Q4 2008 Earnings Call

February 11, 2009 10:00 AM ET


Valerie Finberg - Vice President of Investor Relations

James Q. Crowe - President and Chief Executive Officer

Sunit Patel - Executive Vice President and Chief Financial Officer


Jonathan Schildkraut - Jefferies & Co.

Frank Louthan - Raymond James

Michael Rollins - Citi Investment Research

Ana Goshko - Banc of America Securities

David Dixon - FBR Capital Markets

John Hodulik - UBS

Mike McCormack - J.P. Morgan

Michael Funk - Merrill Lynch


Good day and welcome to the Level 3 Communications Incorporated Fourth Quarter 2008 Earnings Conference Call. Today's conference is being recorded.

At this time I'd like to turn the conference over to Valerie Finberg, Vice President of Investor Relations. Please go ahead.

Valerie Finberg

Thank you, Jessica. Good morning everyone and thank you for joining us on the Level 3 Communications Fourth quarter and full year 2008 Earnings Call.

With us on the call today are Jim Crowe, Chief Executive Officer and Sunit Patel, Chief Financial Officer, who will both be providing remarks on our results. Also with us on the call today are Jeff Storey, President and Chief Operating Officer; and Buddy Miller, Vice Chairman, who will be available during our question-and-answer session.

Before we get started, I need to cover our Safe Harbor statement. Information in our remarks today contain financial estimates and other forward-looking statements that are subject to risks and uncertainties. Actual results may vary significantly from those statements. A discussion of factors that may affect future results is contained in Level 3's filings with the Securities and Exchange Commission.

Also please note that on that today's call we will be referring to certain non-GAAP financial measures. Reconciliations between the non-GAAP financial measures and the most comparable GAAP financial measure are available in the press release which is posted on our website in the Investor Relations section.

With that, I'll turn the call over to Jim.

James Q. Crowe

Thanks, Valerie. In our prepared remarks today, Sunit will start with a discussion of our financial results for the quarter, our expectations for 2009 and our liquidity and debt maturity profile. I will then take over and discuss business operations, a bit about business outlook, and provide a summary, and we'll then take questions as Valerie mentioned. Buddy Miller and Jeff Storey will be joining us for the question-and-answer session.

For those of you who haven't met Jeff, Jeff joined us in December. Most recently he was with Leucadia National Corporation as President of their Telecommunication group. Over the past 25 years he's worked in essentially all facets of the telecom industry beginning with engineering and operating roles within SBC. He was head of commercial broadband service for Cox Communications including its CLEC business, and at WilTel, which he joined after Cox; he was first responsible for all of operations and was then promoted to Chief Executive Officer where I got to know him before and after we made an acquisition of that company.

As President and Chief Operating Officer for our company, Jeff will oversee all of our customer facing market groups, information technology, operations, network planning and network architecture. I look forward to Jeff's contributions and expect that he will share his perspective with you directly on our next quarterly call. Sunit?

Sunit Patel

Thank you, Jim and good morning everyone. We had a solid quarter and a strong finish for the year. Overall, for 2008, we significantly improved our cash flow. We grew core communication services revenue by over 7% and we grew consolidated adjusted EBITDA by 20% factoring out the benefit of the fourth quarter adjustments discussed in the press release.

Unlevered cash flow, which shows the cash flow generating power of the business, grew from 89 million in 2007 to $480 million in 2008. In addition, our net leverage ratio or net debt to adjusted EBITDA improved markedly to 5.9 times compared to 7.5 times a year ago.

Finally, on the debt maturity front, in a year where the capital markets went into a tailspin and froze up, we managed to take care of about 600 million out of about $1.3 billion of debt that was coming due in 2009 and 2010. We now have more than enough cash on hand to pay the remaining 2009 and 2010 debt.

Before I turn to the detailed commentary on revenue, keep in mind that we sold the Vyvx advertising distribution business in June 2008. Core network services revenue, attributable to the Vyvx advertising business, was approximately 11 million in the fourth quarter 2007, 36 million for the full year 2007, and 15 million for the full year 2008. My remarks on revenue results exclude these amounts from all periods.

Core communication services revenue was 966 million in the fourth quarter and grew 2% over the same period last year. Core network services revenue was 785 million in the fourth quarter 2008 and also up 2% over last year. If you assume constant foreign exchange rates during the fourth quarter compared to the third quarter, our year-over-year Core Communication service's revenue growth would have been 7.6% versus 7.2% as reported. This compares to our guidance of approximately 7.5%.

Sequentially quarter-over-quarter growth on the same currency adjusted basis would have been approximately 2% versus 0.2% as reported.

Within our Core Communication's revenue, our wholesale voice services revenue, a business we manage for gross margin contribution was $181 million in the fourth quarter of 2008, up 5% over last year and sequentially.

In the quarter, we continue to see Core Communication services revenue growth from three or four market groups. But overall revenue growth performance continued to weaken as expected.

The strongest performer continues to be our European markets group which, in the quarter, grew 24% in constant currency terms and 7% in reported terms compared to the fourth quarter of 2007. Our Content Markets Group grew 6% normalized and our Wholesale Markets Group grew 2% in the fourth quarter 2008 compared to the fourth quarter of 2007.

Our business markets group declined by 1% compared to the fourth quarter of 2007. During the fourth quarter we sold a portion of our small business markets customer base. While this should help produce some of the ongoing churn in our enterprise business, revenue from these customers was approximately $8 million in 2008. This customer base was sold in November 2008 for approximately 4 million in cash which contributed slightly to the increase in our cash balance but did not to free cash flow.

Other communications services revenue was $68 million down 47% from the fourth quarter of 2007. Of this 68 million -- sorry, 38 million was attributable to the SBC contract. Given that the SBC revenue is now less than 4% of our revenue and declining we will not provide that figure going forward. It will continue to be included in other communications services revenue.

Communications cost of revenue decreased to 414 million in the fourth quarter 2008, down from $444 million in the fourth quarter of 2007 primarily as a result of continued network optimization efforts. These efforts as well as Core Network services revenue growth drove continued expansion in our gross margins which increased to 60% in the fourth quarter compared to 59% in the fourth quarter of 2007. And for the full year 2008, gross margin expanded 90 basis points to 58.8% from 57.9% for 2007.

In the fourth quarter of 2008, as we noted in our press release this morning, we had a few adjustments that affected both SG&A and communications adjusted EBITDA but should not -- but shouldn't be included for run rate analysis purposes. I will take a minute to walk through this fourth quarter 2008 adjustment.

The first is an $86 million non-cash asset retirement obligation adjustment. This adjustment is related to a change in the company's underlying assumptions which were establish in 2003 for future costs it accrues for right of way and leasehold improvement. Upon a full review of these assumptions, including taking into account our actual experience it was determined that a reduction to this liability was appropriate.

Second, is a $14 million litigation expense charge that we took upon conclusion of our patent litigation trial. We largely paid for these legal costs in 2008. Third, is a 12 million charge for severance associated with our December 2008 reduction in force. This charge is not part of SG&A but does reduce communications adjusted EBITDA. The cash cost related to this charge will be incurred mostly in the first quarter of 2009. The fourth adjustment is an $8 million non-cash real estate lease impairment charge associated with lease network and administrative facilities.

Our communications SG&A expense, excluding the adjustments I just described and excluding non-cash stock-based compensation charges, was 348 million for the fourth quarter of 2008, 11% reduction compared to the 389 million in the fourth quarter of 2007. For the full year 2008, taking into account the adjustments I described we were able to reduce our operating expenses by 7% in 2008 from 1.6 billion in 2007 to 1.49 billion in 2008. This is better than the 5% reduction we had indicated.

These reductions were achieved partially through headcount reductions. We reduced headcount from approximately 6690 at the end of the fourth quarter of 2007 to 5275 at the end of the fourth quarter of 2008. In addition, we also benefited from cost reduction initiatives throughout the year, in areas such as headcount related expenses, facilities expenses and better vendor management.

Our SG&A expense as a percent of total communications revenue, was approximately 40% in the first quarter of 2007 and we exited 2008 at less than 34%. Non cash compensation expense was 17 million for the fourth quarter of 2008 compared to $50 million for the fourth quarter of 2007. In our fiscal fourth quarters in the past we generally have seen a higher non cash compensation figure as a result of our discretionary stock grant program.

However, this year in view of the economy and our current share price, we decided not to fund the discretionary year-end grant. In addition, our headcount at the end of the year is quite a bit lower than in the fourth quarter of 2007 which also contributed to the lower non-cash compensation expense amount.

For 2009, we expect full year non-cash compensation to be roughly comparable to total 2008 amounts. Excluding the items I broke out earlier, Communications adjusted EBITDA was 272 million in the fourth quarter of 2008 compared to 246 million in the fourth quarter of 2007. This was a growth of 11% over last year.

For the full year, again, excluding the fourth quarter 2008 adjustments, Communications adjusted EBITDA was 987 million compared to 823 million in 2007, an increase of 20%. Communications adjusted EBITDA margin increased from 22.7% in the fourth quarter of 2007 to 26.3% in the fourth quarter of 2008 excluding the fourth quarter 2008 adjustments. This compares to 24.4% in the third quarter of 2008.

For the full year, also excluding the fourth quarter 2008 adjustments, our communications adjusted EBITDA margin improved by 380 basis points to 23.4% for the full year 2008 compared to 19.6% for the full year 2007. Capital expenditures for -- was 107 million during the fourth quarter of 2008, down from 153 million in the fourth quarter of 2007 and from 123 million in the third quarter of 2008. CapEx for the entire year 2008 was 449 million compared to 633 million in 2007. CapEx as a percent of revenue was 10.5% compared to 15% in 2007. Keep in mind, we had significant integration expenses of the CapEx line in 2007.

During the fourth quarter of 2008, consolidated free cash flow was positive $124 million compared to positive $41 million during the fourth quarter of 2007. For the full year 2008, free cash flow was negative $36 million. This is a marked improvement compared to negative $402 million for 2007. We ended 2008 with a cash and cash equivalence balance of $768 million.

While we do expect to be free cash flow positive for the full year 2009 as is typical, we expect to be free cash flow negative for the first quarter of 2009. This is primarily driven by higher working capital uses related to annual bonus payments, prepayments on maintenance contracts, property and payroll tax payments and normal increases in day sales outstanding on our receivables.

However, we expect negative free cash flow in the first quarter of 2009 to be significantly lower than the negative free cash flow of 160 million we reported in the first quarter of 2008. Depreciation and amortization expense was 224 million in the fourth quarter of 2008 compared with 225 million in the fourth quarter of 2007 and 233 million in the third quarter of 2008. In 2009, we expect quarterly depreciation and amortization of approximately 225 to 235 million per quarter on average.

During the quarter, we announced and completed tender offers for maturities during 2009 and '10 and issued new $400 million of convertible senior notes due January 2013. Through these transactions, we were able to provide liquidity to our bond holders and buy back 40% of our 2009 and '10 maturities. And if you look at all the liability management activities, we completed in the second half of 2008, we reduced our outstanding debt during 2009 through 2012 by approximately $639 million.

We ended the year with $768 million in cash and therefore had enough cash on hand to cover the 694 million in remaining 2009 and 2010 maturities. The net result of the fourth quarter debt transactions had a minimal effect on net cash interest expense. We expect net cash interest expense in 2009 to be similar to 2008 of approximately $510 million and as we are paying down debt in 2009 and throughout 2010, we should be roughly in the same range for 2010.

For 2009, we expect to deliver another year of adjusted EBITDA growth from the 988 million reported in 2008, free cash flow growth, and to be free cash flow positive for 2009. Revenue has some near-term pressures as we discussed in the press release but the efforts in investment put into improving our customer experience, processes and systems will start to yield benefits especially to our Business Markets Group later this year. Our European Markets Group continues to provide steady growth.

In 2009, we expect to improve adjusted EBITDA margins from 2008. This should come from continued network optimization and operating expense reductions. Also given sales and revenue growth trends in the second half of 2008, we expect capital expenditures would be significantly less in 2009 compared to 2008. As a result of all these expense improvements offsetting any revenue pressures, we expect good free cash flow performance in 2009.

With that, I'll turn the call back over to Jim.

James Q. Crowe

As noted in the release and I am sure it's not a surprise to anyone on the call, there's uncertainty to say the least with respect to the financial system and now increasingly the effects of that uncertainty on the macro economy. Near term, we have no special ability to forecast the affects of this uncertainty on demand for our products and services.

Consequently, we have and will continue to take actions to ensure we meet three goals. Firstly, we want to make sure our cost structure is appropriate for a wide range of potential revenue growth rates. This means cutting costs now to levels appropriate to a conservative assessment of revenue growth.

In short, we prefer to reduce cost now and find we've been too pessimistic rather than the reverse. We want to continue to improve our credit quality to improving EBITDA and cash flow and appropriate deleveraging transactions. This quarter continues to demonstrate the significant progress for making in this regard and I'd be remiss if I didn't congratulate Sunit and his team on getting a transaction done at a time when I think very few were able to do anything similar.

Third, we want to ensure that we are positioned to take advantage of the opportunities that will certainly emerge as the longer term positive fundamentals of our business display short-term challenges. I think that comment bears some explanation. But both Sunit and I have commented on near-term revenue challenges, we expect that many of the causes of this slowdown in purchasing are temporary, and we continue to believe that underlying growth and demand and pricing fundamentals of our market remain positive.

We believe this is particularly true for our wholesale markets group which I will discuss further in a moment.

Specifically, Jeff Storey is leading an effort to make sure our network, operating and capital expenditures are aimed at areas of greatest future returns. We believe it just has occurred after the telecom turmoil which occurred earlier this decade. Significant opportunity will be available to those who are positioned well. What is different versus the last difficult period is our own market financial and operating position, all of which are far better than they were at that time. That means we have significantly more resources to take advantage of opportunity as they arise.

I will now discuss each of our business unit result. Total -- my figures as Sunit's were -- are adjusted to reflect the effects of the sale of the Vyvx ad business as explained in the press release. Also Markets Group segment comprises about 49% of Core Network Services revenue and grew about 1% quarter-over-quarter. This growth rate we think is a reflection of customer cost management and we believe a general trend to differ purchases and run networks with less capacity available for traffic spikes.

We observed this same dynamic during the telecom market turmoil and we expect that just as it was this last time that the effect will be temporary since underling unit demand remains strong and we think we will eventually mandate network augmentations.

Our business Markets Group contributes about 29% of Core Network Services revenue and continues to display essentially flat to slightly declining top line growth. We are focused on improving results of this unit by lowering churn, by expanding our sales, by broadening both our service portfolio and our geographic focus.

Our Content Markets Group represents about 13% of Core Network Services and grew 2% quarter-over-quarter. Revenue growth was still robust slowed somewhat due to one time migration of certain IP traffic to previously sold dark fiber based networks, disconnects by one large customer and by some smaller less well funded companies.

However, we remain confident about longer term prospects for this unit giving the increasing importance of internet distributed video and I will have a bit more to say when I talk about content distribution product segment.

Our European market group comprises approximately 9% of CNS revenue and declined 8% quarter-over-quarter, because of, as Sunit explained, negative currency adjustments. Adjusting for this effect quarter-over-quarter, growth was 9%. Today this unit has not experienced any negative effects created by the economic situation although we do continue to monitor the situation closely, especially, sales cycle durations.

Overall, Core Network Services revenue grew approximately 6% year-over-year. Also voice services generated about a 180 of revenue in the fourth quarter up 5% quarter-over-quarter and 14% year-over-year. This segment benefits from a very deep metro network interconnection and has become a significant contributor of gross margin and cash flow.

I will now discuss pricing and demand trends. As I noted across most of our products the pricing environment remains generally healthy as evidence by the ongoing stability of our incremental gross margins. Continuing the trend we have seen for a number of quarters, transport and infrastructure services, including long haul and metro dark fiber, wavelength, private line, IPVPN and our Ethernet based services prices are generally stable, and in some cases such as co-location and dark fiber are actually up in absolute terms.

High-speed IP is quite -- is a very different dynamic. We continue in this segment to expect long-term price declines in the 25 to 30% range with unit demand growing at a rapid clip to offset unit price demands or declines.

As we have repeatedly pointed out bandwidth demand and including demand for high-speed IP is increasingly fungible or substitutable across information, transport, IP and CDM services.

This means that in any given quarter demand for individual services can be somewhat volatile and should be -- not be used to extrapolate future growth rates for those services and more importantly for the internet itself. We continue to believe that certain industry and competitor reports of slowing or increasing growth rates of the internet are often explained by customers shifting between various services or perhaps even to dark fiber based solutions rather than actual fluctuations in aggregate demand. This emphasizes the importance of having a broad set of IP and optical services provided over an owned physical network, a definite strength of our company.

CDM serve -- for CDM services, demand continues to be very strong. And let me take a moment to define CDM since that term is used fairly broadly. As we use it we refer it to large object of video distribution either streamed or stored and forwarded over the internet as opposed to smaller object distribution i.e. web page acceleration, e-commerce solutions and the like.

During the quarter, we had annualized CDM revenues of approximately $100 million, a significant growth rate and a demonstration of the strength of our market position. Pricing is still what we would refer to as early stage given the overall immaturity of the supply chain.

Finally, voice service pricing remains stable to slightly down across the board. I will now turn to our ongoing efforts to improve our customer experience from initial discussion of requirements through billing and customer care.

I am pleased to say that the frame work of our integrated set of processes and systems which we refer to as Unity is now largely in place and we met our goal of processing more than two-thirds of CNS orders or -- that is core network services orders through the system. We are now turning our attention to the continuous improvement of these processes and system and most especially to improving the data integrity of network inventory systems which underlie our databases which underline these processes.

This effort is an important part of our job to both increase revenue growth rates while at the same time improving operating margins. That concludes our prepared remarks. Operator, would you explain the Q&A process.

Question-and-Answer Session


Thank you. The question and answer session will be conducted electronically. (Operator Instructions). We will take our first question from Jonathan Schildkraut with Jefferies.

Jonathan Schildkraut - Jefferies & Co.

Great, thank you. Just a couple of questions here. First, Sunit, on the CapEx side of the equation, now this year was a fairly low number as you mentioned 10.5% of revenues; on the third quarter call you said the long-term kind of CapEx trends would be somewhere in the 12 to 14% range. So you pointing to the CapEx being down meaningfully year-over-year. Can you talk to us about where you're going to hold-off on spending and where the company will continue to spend over the next 12 months?

Sunit Patel

Sure. I mean as you know a lot of our CapEx driven by revenue growth so is clear linkage between revenue growth and CapEx expense. So as revenue growth slows down our CapEx comes down along. We do have a certain level of maintenance CapEx as we've mentioned in the past about $200 million.

And then some CapEx even at lower revenue growth just because your churn in your business so it takes some time to reposition the capital that gets churned out or as revenues get churned out or reposition. And so given that you've seen that the revenue growth has slowed down especially in the second half of the year and -- both from a sales perspective and a revenue perspective, we think that again we won't spend as much capital even in the first half for example because the revenue picture from a growth perspective is different from where we were same period last year.

So, we think that because of that, because of revenue growth and because of a lot of our CapEx is success based capital driven by revenue, it should come down quite a bit again in 2009.

James Crowe

Yeah. I'd point out too, we do continue to invest on a third category project capital. One example that we've noted is the great opportunity supported by great results we have in Europe and we continue to tell our European operations take the capital, but you need to continue to expand in areas where opportunity is the greatest. Similarly in the U.S. we continue to expand networks and add buildings where those create additional opportunity.

Operator, next question?


We'll take our next question from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Great. Thanks, Jim. On that where do you guys see your best opportunity here in the market? There's obviously a lot of pressure here, but where do you see, is it in Europe or is it more on wholesale and then what're you seeing on the pricing trends. You heard yesterday Qwest increasing some wholesale pricing, does that helping drive some customers to you, are you following with raising or holding the pricing steady, what's the prices trend there?

James Crowe

Yeah, the first question, where do we see the greatest opportunity to invest incremental capital? As we've said previously, we continue to allocate capital to improving our balance sheet, that's our key goal. But longer term there is an enormous opportunity, almost without limit. Then Buddy Miller has addressed this opportunity over and over in his public remarks to increase or to expand our metro footprint to the literally tens of thousands of locations which justify fiber today but which are not currently sold or served by fiber.

We've said publicly that there are over 100,000 points of traffic aggregation, buildings, internet traffic centers, COs, within 500 feet of our network and that represents a fairly large opportunity, one that we think Level 3 is rather uniquely positioned nationally to take advantage of.

With respect to your question about pricing, in general, I think I provided some detailed comments in my remarks. In general, we've said and continue to say that we expect that relative pricing long haul versus local we will continue to favor local that metro particularly special access will continue to see relative price increases, if not absolute, and we would say we think you are going to see and are seeing absolute price increases for special access.

These -- it's hard to track because they are generally negotiated contracts between the suppliers and the purchasers. The SEC eliminated about two months ago any requirement to report any of that information but we and many others have noted that the suppliers of access. Qwest certainly is one, the other RBOCs or integrated telcos or others; we're a supplier are increasingly selling the scarce facility and we'll see the result.

Next question?


We'll take our next question from Michael Rollins with Citi Investment Research.

Michael Rollins - Citi Investment Research

Hi good morning. I was wondering if you could talk a little bit about where you think on a dollar basis SG&A -- cash SG&A can get to on a quarterly basis. And also, could you just give us an update in terms of where the share count ended at the quarter, and were there some specific debts for equity exchanges in the fourth quarter? I know there is a brief mention of what you did for the year in the press release but just curious in some more details of what happened in the quarter. Thanks.

Sunit Patel

Yeah, I will start with the last question first. They were no debt for equity exchanges in the fourth quarter; we otherwise would have mentioned that specifically. The share count that we ended up which was 1.617 billion shares or 1.618, I guess rounded to the nearest million. The SG&A expense, as I mentioned, we mentioned at your conference earlier in January, we look at it from a SG&A as a percent of revenue perspective and we said that we would exit in 2009 in the lower 30s and as you can see already in terms of existing 2008 we were less than 34%. So I think that -- we manage that on a continuous basis and we feel comfortable with what we said at your conference which is we expect that we'll be able to manage that down again. So when we don't talk about EBITDA margin expansion, I think you will see that benefit come yet again from SG&A over the course of this year, and a little less on the gross margin side.

James Crowe

Longer term, Sunit, you might talk about incremental SG&A --?

Sunit Patel

Yeah, I think that's a good way to look at it. I think when we look at -- we've said in the past that from a gross margin perspective for every new dollar or Core Network Services revenue we add, the incremental gross margin is about $0.80 and similarly the incremental SG&A cost for every new dollar or revenue we add is probably in the $0.15 range. So I think that gives you an idea that as we grow revenues or the rate at which we grow revenues we should be able to take that SG&A as a percent of revenue down just because of the operating leverage we have in the business.

James Crowe

And to add --

Sunit Patel

And the short-term, I would say, we are doing it just to finding more cost efficiencies as we have over the last -- over 2007 and '08, and I think that will continue in 2009.

James Crowe

Yeah, just -- I'd add that in the shorter term because what we are seeing SG&A drop in absolute terms, we have obviously no incremental or negative incremental SG&A. But longer term, as Sunit described, $0.15 give or take per dollar of incremental revenues are target, Jeff Storey's job is to make it $0.14, $0.135 and that's the whole goal of improving our processes and systems.

Next question?


We will take our last question from Ana Goshko with Banc of America.

Ana Goshko - Banc of America Securities

Hi. Thanks very much for taking the question. First question is on the cash balance going forward. So, it's definitely looking better that you've got a cash balance at least to begin the year that could address the maturities through 2010. But as you noted, Sunit, you do have fluctuations in your working capital from quarter-to-quarter. So, I wanted to know what's your comfort level on a minimum cash balance and if you thought about potential ways to put in some kind of revolver or backup facility that could potentially give you the cushion that you might need to go through some temporary fluctuations quarter-to-quarter as you progress through '09 and '10?

Sunit Patel

Yeah, I mean what -- what we'd say is we've always generally maintained pretty healthy cash balances. I think that approach will continue obviously a need for maintaining larger cash balances, and certainly need less when you're free cash flow positive versus when you have large free cash flow losses.

So, I think that what we might have needed in the past, we need less but we've always been big delivers in maintaining healthy levels of liquidity. And I think to your other point I think we -- we will always and are continuing to look for ways to boost our liquidity through means. We have flexibility to raise financing on a secure basis through various means. And I think we will just continue to explore options over the course of this year to boost our liquidity. I think that something that's a constant effort for Robin, our Treasurer and I. So we'll continue to focus on that.

Ana Goshko - Banc of America Securities

Okay. And then if I could just follow-up on -- with one more, on the business side in your Enterprise segment I wanted an update on the kind of turn you're seeing. So when I think about churn there's two buckets. There's the sort of churn that you don't really mind and you talk about these acquired small customers that are not necessarily profitable and you don't mind to seeing those customers leave or you are in fact selling them. And then you also obviously had some economic churn that is probably not desirable. So I wanted to get some anecdotal insight into what those two buckets are and as you look forward, do you look at sort of -- how much of your enterprise revenue base is at risk in either one of those buckets?

James Crowe

Let me make sure I understand the question, are you asking broadly across the company or just with respect to BMG, the Business Markets Group?

Ana Goshko - Banc of America Securities

The Business Markets and in particular wanted to get a sense for what percent of your churn is really churn that you don't mind incurring and how much of that is still left in your base?

Sunit Patel

I'd make a number of comments. First, we -- when -- the term we don't mind I'd expand a bit on; we were in the business of providing customer service so we don't want any customer to have a bad experience. There are certain segments that don't fit our long-term module. That is our cost to provide service to that segment exceeds long term the module that we have for our business.

I will give you an example of this. We had residential long distance customers. We are not set up to provide service to that or don't want to be set up to provide service to that segment. We expect that those segments that we don't long-term want to retain largely to be gone by midyear. I would add one caveat, Jeff Storey and the team at BMG are reviewing that question continuously and it has obviously to do with how you discount future cash flow, retaining customers may have a different value to us today than it did two months ago or two months from now, so, that's always a caveat. With respect the actual numbers we haven't provided those numbers, I'd simply observe that we -- our churn, we think, is actually across all our business units at or below what we would expect for many of our competitors.

Next question?


We will take our next question from David Dixon with FBR Capital Markets.

David Dixon - FBR Capital Markets

Thanks very much for taking the question. Question for Jim and Sunit. I was just focusing on the recent revenue trends and we're seeing substantial CapEx reductions, for example, from Google this year, one of your major dotcom (ph). There is mix of obviously server data center and network spending declines in that mix. Jim, I wondered if you would able to characterize for us their recent network spending trends there and if there had been any changes and if it is declining we would anticipate seeing that revenue being replaced going forward. I think just on that point we're also seeing that Comcast appears to be continuing with the progressive switch from mainly (ph) fiber to dark fiber across various network sectors. And so just those two customers seeing trends there interested in your thoughts on that. And then I just had a follow up on headcount. Thanks.

James Crowe

I can't comment on a specific customer as I said a number of times. Customers have varying views about what they want to make public and what they don't. And -- but I will comment broadly about your question or at least as I understand your question. And I'll use the customer that has given us permission to discuss the situations specifically. You mentioned Comcast, Comcast is a good example perhaps of the underlying dynamic that you're addressing.

Sometime ago when it was around 2003 if memory serves, Comcast wasn't a large customer, approached us to buy dark fiber network, they wanted to move some of the traffic bought from a variety of suppliers to the wrong network. We had quite a long discussion about the merits of that and ended up selling to them. Since that time Comcast has become a very large customer. And that dynamic I've described a number of times, I'll describe it again.

No one customer regardless of their size has the kind of scope and scale that we do. We represent depending on his numbers you want to hook -- look at something approaching 20% of the internet. We have a very large portion of the market for waves -- for dark fiber, et cetera, all the way up to content distribution.

When someone buys a dark fiber network, by definition they interconnect physically with Level 3 where they have sufficient traffic and move it economically to that dark fiber. But other areas they buy waves, they buy private lines, they buy transit, they might, depending on the customer, they might buy voice services, voice termination services, content distribution. And while we certainly need to earn the business we think we are in a better position after interconnection not just physically but our network operating centers, network architecture for instance if you buy dark fiber you are in our facilities. It makes some sense to coordinate equipment purchases, architectures, types of equipment with us.

All of that's a very long-term trend and I do not believe there is an exception where we have physically sold fiber on any kind of major basis and interconnected where that hasn't been a positive for level 3.

And even more broadly, your question I think may have to do with cutbacks. I think I touched on that in my comments. Just as in the telecom turmoil, we have said and continue to say some sales cycles are lengthening particularly in wholesale. We haven't seen them lengthen anymore this quarter, but they -- they still remain longer. Customers are taking more time to buy, they are running networks harder. But underlying growth for internet IP optical services, wireless services; those two represent probably 70, 80% of our -- the drivers of our revenue, continues very strongly and seems to us if anything may increase in times of turmoil.

Next question?


We will take our next question from John Hodulik, UBS.

John Hodulik - UBS

Hey, thanks, good morning. Just I guess I realized you don't have a ton of visibility under -- on the revenue line but just looking at the guidance here, I mean, can we expect or deserve, are you trying to imply from your guidance that core network services revenues will decline in '09 versus '08? Any sort of color you can give there?

And then I guess going for some granularity on the two bigger segments there, wholesale and BMG, the churn you are talking about in wholesale, I guess you may be referring to at least Alltel that traffic is transferred over. Is there a way we can get a sense to sort of size the disconnects that you may be seeing in the wholesale side and how that sort of may play out throughout '09?

And then lastly BMG, it sounds like higher trend in the low end, but obviously AT&T and Verizon are seeing some issues as well from a business market growth. I mean do you expect the declines that you are seeing there or the pressure to get worse before they get better or how do you expect that to trend out?

James Crowe

I don't think we are going to go past what we have said in the press release and in Sunit and my remarks about revenue, because of the volatility. I would emphasize as we did in the press release as Sunit did and I -- as I did. We think because of the dynamics I just described and will repeat that we are talking about short-term uncertainty, short-term lack of visibility. Long-term we've seen nothing fundamental that would say demand for IP optical services there's anything other than continuing at historically high rates and that inevitably as it did the last time we saw a slowdown we'll reflected -- be reflected I customers needs to purchase.

With respect to churn, I want to be clear here, we haven't said and are not saying that churn in WMG is unusual or high by historical standards. What we've said is that customers are taking more time to make purchasing decisions. The dynamic you've described, the purchase of Alltel, there's nothing unusual about that. We saw AT&T and SBC merge, we saw the resulting company buy SBC; we saw Verizon purchase MCI WorldCom. Every time that's occurred we've had questions about its effect on our business. We said net-net we see opportunities and we see those entities groom their networks.

They reduce their spend in some areas outside their service territories. They continue to buy and we're a logical choice. So there's nothing unusual in that transaction that you described. We don't see anything unusual. It's -- what we see is customers taking more time and being more cautious in a period of uncertainty.

John Hodulik - UBS

Okay. I'm just trying to make sure that there -- you won't see any outsized effects from say that deal or any other --?

James Crowe

I don't think we've seen anything that is unusual in historical terms. With respect to business markets group, we are about 3% of the business market. I look forward to having a discussion publicly of the kind that AT&T and Verizon have because they are dominate providers, and they are sensitive to the overall macro economy. If overall economy shrinks, that affects someone with 60 or 70% market share. As someone with 3% market share our challenges, our difficulties and most importantly our opportunities are our own to make. We create market by taking share. So, whether the market grows by 5% or shrinks by 5% is far less important than our own internal ability to convince customers we are a better choice than the incumbent. And that's where we are focusing all our time and energy.

Next question?


We'll take next question from Mike McCormack with J.P. Morgan.

Mike McCormack - J.P. Morgan

Hey guys, thanks. Yeah, I guess maybe just a follow-up on the lat question on the revenues side. We've always talked about accelerating revenue growth towards the back of the year and obviously this year was the opposite. I just want to get maybe a sense for the magnitude of cash cost reduction that you're anticipating to get that EBITDA to be slightly up year-over-year. And then secondly, on the deferred revenue, can you break down, Sunit, maybe the takedown differences between the amortization piece versus the FX? Thanks.

Sunit Patel

I think first on the cost reduction side, I don't think there's anything unusual. If you just look at the -- our track record just over the past couple of years, every time we put in a new systems implementation or new processes in place, just manage to squeeze out more efficiency and productivity. And I think well we're just going to continue to do the same. So in overall magnitude terms, I don't think there's anything large in relationship to our total SG&A expenses.

But again we still see a favorite opportunity and then the other area is that when you put seven companies together as you take on a lot of long-term -- these commitments and as those -- well on the network side and on the SG&A side and as those come up for expiration renewal, you trim costs that way also. So I think that benefit or that opportunity's there for us again this year and over the course of the next few years.

And then on deferred revenue, I mean as we've said for some time there's nothing big happening on the deferred revenue side in general over the last year as we've been in general been able to replace our -- whatever we book in, I mean, non-cash amortized revenue with cash our new sales. And if you look at the most recent quarter of the change about half -- the deferred revenue balances went down, about $23 million, about half was FX rate meaning that as the dollar strengthened, the amount of deferred revenue balance for fiber that we would have sold back in Europe that would go down just because the dollar goes up. So it was about half of the $23 million change from Q3 to Q4.

Mike McCormack - J.P. Morgan

Great. Thanks guys.

James Crowe

Next question?


We'll take our next question from Michael Funk with Merrill Lynch.

Michael Funk - Merrill Lynch

Great. Thanks again guys. If we could just focus in on the churn again, you talked about the economic environment driving churn enterprise? Can you give me a sense of the breakdown between, I guess, the competitive churn and then it's economic driven or business closure churn, and any kind of color here would be helpful.

James Crowe

Yeah, I don't think the latter business -- businesses going out of business, there's anything different today than it has been historically and it isn't a material contributor. A part of that is Sunit and his group do a fine job coming out of turmoil of 2001, '02, '03 of credit checks, so we just have talked about that past conference calls.

Maybe this -- I'll try to answer your question this way. For customers who we build less than 2000 a month, churn is higher than we want and institutionally expect for a variety of reasons. From 2 to 5000 we're holding our own. Above 5000, we are seeing nice growth. So, obviously that dynamic underlies our comment that churn can only go so far and at that point we'll see growth from the segments that continue to show revenue and then sales. I think that's about as far as I will go. I think we have time for one last question.


We will take our final question from David Dixon with FBR Capital Markets.

David Dixon

Well thanks gentlemen. Just a quick follow-up on the headcount. I just wondered if you could concern for us the sizing of the sales force at yearend Sunit and your objectives for sales force growth in 2009 or changes in that area; I think we got the total head count there. And then secondly, just a sense of the split between the contracted mix and then employee mix. So I imagine you would be seeing some opportunities here in '09 to wind down some of the those contractors as some of those projects are coming to exploration. Thanks very much.

James Crowe

Let me take the first one and Sunit you can take the question about contractors. I assume that's as opposed to business solution partners. But with respect to our sales headcount we exited the year at 450. We've added 10 in the month of January. So we are at 460. We continue to say and manage around what we say sales people we will add as appropriate. We'll match sales to opportunities. We said at the beginning of the year prior to the economic turmoil that we thought around 500 was the appropriate number. We are at 460; Jeff Storey and his team will continue to monitor and see if that's the appropriate number or we should add more.

Do you want to add to --?

Sunit Patel

Yeah. On the contractors, we have sort of two categories. We have business solution partners, which is a reasonable chunk. I'd say about 1600; lot of those offshore.

In terms of other contractors that are on sight if you like the U.S. and Europe, but it's not more than a few hundred and it's been in that category and you are right we -- and that is the other thing we continue to look at to trim that down and save money in both those areas and I think that we've got a fair amount of reductions within the workforce and we are now also looking at the outside resources that I described to look for reductions there over the course of this year.

James Crowe

Yeah, let me just add a point or two. When we talk about business solutions partners, we went through quite a extensive effort to divide our processes into those that we think are core, that is, we want to control because they directly affect the customer experience in a way we think differentiates us. We always look at that that is in a constant that needs to be reviewed continuously as you change your services, you change your processes.

That -- the parts that are non core, we've off-shored if you would, that's the roughly 1600 people that Sunit mentioned. In addition, we have efforts for instance software development that fluctuate. We -- those are contractors, I believe, if I understood your question you may be referring to those job shoppers as another term. We hire them daily, weekly, and those we do expect to see reduced but those aren't a major part of our roughly 6000 plus employees plus 1600 offshore or business solutions partners.

All right, let me thank everybody and with this as has been noted on every conference call that I've seen visibility is certainly limited. However, I'd point out both our company and its employees have significant experience with periods of uncertainty. We went through something similar. Well, I won't use the word similar, I am not sure if it is similar. But we went through industry difficulties of a similar magnitude in the early part of the 2000s; in fact at that time it fell worse.

Today, however we have an industry environment and our own position is much better than it was at that time. I think some of the questions noted and we would repeat that not just Level 3 but other participants in our industry have noted that for some of our competitors call wholesale and data, we would call IP and optical services, pricing and demand are far better today than they were at the beginning of the decade.

And for Level 3, we have a large growing and much, much more diversified revenue base. We've got products and services that match our customers' needs and we certainly have the kind of operating leverage that we talked about achieving four, five years ago and are apparent in our financials today.

Most importantly, we have positive and improving free cash flow. So about -- almost every operating measure we are in a far better position than we have been in any time in our history. We have the people and the assets, we think, positioned properly to benefit from opportunities which always arise when you have turmoil.

Thanks for listening and best of luck to all of us. Operator, that ends the call.


This concludes today's Level 3 Communications Incorporated fourth quarter 2008 earnings conference call. Thank you all for attending, and have a good day.

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